ABSOLUTE ADVANTAGE: The general ability to produced more goods using fewer resources. This idea of absolute advantage is important for trading that occurs between both people and nations. A nation can get an absolute advantage from an advanced level of technology or higher quality resources. For a person, an absolute advantage can result from natural abilities or the acquisition of human capital (education, training, or experience).

Any item used as money in an economy automatically takes on four basic functions: (1) medium of exchange, (2) unit of account, (3) store of value, and (4) standard of deferred payment. While "buying and selling" means that money is THE medium of exchange, and by far THE most important function of money, money also performs unit of account, store of value, and standard of deferred payment functions.

Money provides four key functions for an economy: (1) medium of exchange, (2) unit of account, (3) store of value, and (4) standard of deferred payment. Medium of exchange means that money is used to conduct transactions. Unit of account, also termed measure of value, means that prices are stated in terms of money. Store of value means that value, the satisfaction of wants and needs, can be stored over time using money. Standard of deferred payment means that future payments, such as paying off a car loan, are also in terms of the monetary unit.

Medium of Exchange

THE primary function of money is to act as THE medium of exchange. People use money to buy and sell goods. Buyers give up money and receive goods. Sellers give up goods and receive money. Money makes transactions easier because everyone is willing to trade money for goods and goods for money.

To see why money makes transactions easier, consider a barter economy that has no money, where one good is traded directly for another. The key to successful barter trades is double coincidence of wants, each trader has want the other wants and wants what the other has. Without double coincidence of wants, a barter economy can become exceedingly inefficiency. Traders spend more time seeking trades and less time producing goods.

Suppose, for example, that Duncan Thurly heads into town with a basket full of hand-crafted hamster hats (not hats made FROM hamsters, but hats made FOR hamsters) which he hopes to trade for a pair of knickers--what others might call pants. If the local knicker-maker (Kevin) needs hamster hats, the there is a double coincidence of wants and they are ripe for a trade. However, if Kevin the tailor has no desire to acquire hamster hats, then there is NOT a double coincidence of wants and Duncan does NOT get his knickers.

At least he will not get his knickers without spending some time, perhaps a great deal of time, seeking to trade his hamster hats to someone else for a good that the tailor does desire. Duncan might need to seek out dozens of other people, conducting dozens of intermediate trades, before he finally has a good that can be traded for knickers. The time he spends on barter trades is time that he CANNOT spend fabricating additional hamster hats, to the loss of hamster owners worldwide.

Money eliminates the need for double coincidence of wants because EVERYONE is willing to accept money in payment for goods. Duncan can trade his hamster hats for money (that is, sell), trade this money for the knickers (that is, buy), then returned home for further hamster-hat fabrication. With a generally accepted medium of exchange, trades are easier, more efficient, and resources can spend more time doing production.

Unit of Account

The second function means that is money is being used as the common benchmark to designate the prices of goods throughout the economy. Unit of account, or measure of value, means money is functioning as the measuring unit for prices. In other words, prices of goods are stated in terms of the monetary unit.

If Duncan Thurly is heading off to the market in search of hamster hats or tailored knickers, then he will find each has a price in terms of the medium of exchange. If his society make use of U.S. dollars, then hamster hats carry a U.S. dollar price. If he lives in a land that uses German marks, then knicker prices are in terms of marks--German marks.

The reason is that sellers are willing to trade for, and buyers are willing to give up, THE medium of exchange--money. That is why money is THE medium of exchange. It is used for exchanges.

Using money as the unit of account for prices, however, also provides a measure of value--how much value buyers and sellers place on a good. If tailored knickers carry a $10 price, while hamster hats go for $5 each, then this indicates a measure of the relative value of each commodity--knickers have twice the value of hamster hats. Buyers are willing to give up twice as much money to buy a pair of knickers as to acquire a hamster hat and sellers incur twice the opportunity cost of producing a pair of knickers as that of hamster-hat production.

Store of Value

The third function, store of value, emerges because money is one way of postponing the satisfaction obtained from using or consuming goods until a later time. Value is obtained from a good when it is consumed, when it is used to satisfy wants and needs. The value from consuming goods can be stored in several different ways, one of the best is money.

Consider a few ways that Duncan Thurly might be able to store the value of a $2 hot fudge sundae for one week.

First, he could buy a freshly fabricated hot fudge sundae for $2 and store this product for seven days. Successful storage requires a freezer, especially during the summer. Would this hot fudge sundae retain its full $2 value one week hence? Probably not. The hot fudge is likely to be cold. The whipped topping is probably unwhipped.

Second, Duncan could purchase a $2 gift certificate from the ice cream parlor, a coupon that is tradeable for one hot fudge sundae. After a week, he can redeem the certificate and enjoy his treat. In this case the value of the sundae is stored in the coupon. While this is a relatively good store of value for the hot fudge sundae, it ONLY stores the value of a hot fudge sundae. A hot fudge sundae coupon cannot be used to store the value of other goods.

Third, he could take his $2, use it to purchase another good, like a book, hold onto it for a week, sell it, then use the proceeds to buy a hot fudge sundae. Of course, if the book is not very liquid, meaning that it cannot be easily converted into money, then he probably will not end up with the $2 that he needs to buy his hot fudge sundae. Storing the value of one good by purchasing then later selling another good is seldom the best way to go.

Fourth, Duncan could simply keep $2 stashed away in his billfold, sock drawer, or coffee can buried in his back yard. After one week, he can then amble down to the ice cream parlor with this $2 in hand to make his hot fudge sundae purchase. In this case, he has stored the delicious value of the hot fudge sundae in the form of money.

The problem with storing value in money is price changes. If the price of the hot fudge sundae rises during this week, then Duncan's money becomes a less effective means of storing value. As a general rule, price inflation is the nemesis for the store of value function of money.

Standard of Deferred Payment

This fourth function means money is used as a standard benchmark for specifying future payments for current purchases, that is, buying now and paying later. This function may seem obscure, but it is a direct result of the store of value and unit of account functions.

A common example of deferred payments is a car loan. Duncan Thurly get a loan to buy a car today, then pay off the loan with payments deferred into the future. The amount of those future payments are stated in terms of money.

Using money as a standard of these deferred payments is a direct consequence of the unit of account and store of value functions of money. If money is the standard for current prices, then money is also the standard for future payments based on those prices. But, for money to function as a DEFERRED payment standard, it must retain value, it must store value. The key to storing value in money is price inflation.

This means that deferred payments need to anticipate future money values based on future inflation. If inflation is, for example, 10 percent next year, then deferred payments need to be adjusted for the resulting decline in money value. This inflation adjustment is accomplished by through interest rates.

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